Distressed debt a new asset class in Asia

Distressed debt a new asset class in Asia

By Andrea Ricci

HONG KONG (Reuters): Asia's decline in fortunes has created a new class of securities previously associated with troubled Latin economies but not robust Asia -- distressed debt.

With currencies of many countries sharply weaker, numerous companies have found themselves unable to service their external debt, forcing them to restructure or default.

Many more are current on their obligations but are the victims of poor sentiment, which has caused Asian debt paper prices to plummet.

The debt of all of these companies can be considered distressed. And there are investors who will take it.

So investment banks are taking a closer look.

"I wouldn't say that it is a change in focus for us," said Ivan Lee, vice president and head of fixed-income research at Salomon Smith Barney.

"I would say that the distressed debt market is attractive enough for us to have a serious look at the market and put some resources there," he said.

Raja V, vice president at BA Asia, said distressed debt is not easy to define but can be split into three broad categories.

"The first category are those companies that are going through a prolonged period of illiquidity. In this category, all you are looking for is the catalyst that turns them from being illiquid into liquid and viable investments," said Raja.

The second type are companies that have been growing beyond sustainable growth rates and are overextended financially.

"These are the ones that an investor is really looking at from the point of view of M&A (mergers and acquisitions) activity or assets sales, normal corporate restructuring," he said.

The third are companies that are "pure and simple junk. What you are looking for there is terminal asset values", he said.

Salomon's Lee said many bonds and loans in Indonesia are distressed in terms of their yield spreads.

"Have they defaulted? No. They are still current. But because of the perceived risk of the parent, the trading level can be distressed," he said.

Potential returns with distressed debt are high, but so are the risks. Investors take on distressed debt in the hope that the big money that can be made on a few deals will make up for losses on the rest.

Most investors are U.S.-based funds that have experience with distressed Latin American debt or got into the market in the late 1980s when the U.S. real estate market tumbled.

Asian investors are just starting to get into the game.

Both types of players have something to learn.

"There are Asian players that are not used to buying distressed debt, but they know the Asian market," said Douglas Tanner, senior partner in Asia for Milbank, Tweed, Hadley and McCloy, a law firm advising debt holders and investors.

"Then you have a lot of people in the U.S. which are very sophisticated buyers of distressed debt, but they don't know anything about Asia. So over the last three months it has been a process of education on both sides, one learning about distressed debt, the other learning about Asia," he said.

Investment banks are gearing up for the nascent market, putting more resources into credit research.

"You have to have good traders or good salespeople that can source paper, or you need to have a lot of people that are very close to the companies, who would know what their funding profile is, what their funding gaps are and therefore would know what money they need and when they need it," said a fixed-income manager at a U.S. bank.

"It is very detail-oriented sort of stuff, it's not sexy, it's not glamorous. People think it is, but there is actually a lot of drudgery that goes into making money in it," he said.

The same problems that plague Asian debt markets generally -- a lack of transparency, poor corporate disclosure and unclear bankruptcy laws -- become magnified when the debt in question is distressed. Clarity varies significantly by country.

"If you look at Hong Kong and Singapore, the legal recourse available to the creditors is very comfortable and the disclosure level in terms of the integrity of the financial statements is quite reliable," said Lee.

"When you get into countries like Thailand and Indonesia, where the bankruptcy laws are still being developed, the uncertainties there obviously are higher. And Malaysia and Korea are in between," he said.

How much clout debtholders have in forcing a company to restructure also varies by country, and by company.

"If you have a company that needs to do an international financing to continue to expand its business or to meet its obligations then the holders of its existing debt have a lot of leverage," said Tanner.

But, he said, "I have not seen evidence that holders of distressed debt have been able to exercise substantial leverage out here in Asia."

The outlook for improved bankruptcy laws is good, however.

"By and large, the legal systems are converging on the U.S. style, which is one of the reasons that many of the vultures swooping around are Americans," said the fixed-income manager.

Other factors also can cloud the picture, analysts said.

"Sometimes, there is a discrepancy of information, so that investors think the debt is hedged and then find out it's not," said C.K. Kong, vice president, Pacific credit research, at Credit Suisse First Boston.

Salomon's Lee said the supply of Asian distressed debt ultimately could be in the tens of billions of dollars. But trade is as yet modest and liquidity very thin.

"The market is very new and not well developed. A lot of investors are doing their homework at this stage and are very selective," Lee said.

Existing creditors, meanwhile, are still deciding whether they want to sell their portfolios.

Some investors have complained that Asian distressed debt is too richly priced, a problem Lee attributes to existing creditors' unwillingness to sell the debt at a deep discount.

"We are seeing quite a lot of interested buyers, but they are not aggressively buying, which is an indication that they think the price is on the expensive side," he said.